The Alarming Lesson of Winklevoss V. Facebook Appeal by cwinklevoss

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									The Alarming Lesson Of Winklevoss V. The Facebook

Law360, New York (August 23, 2011) -- Although we have been involved in many high
profile appeals, none has generated the kind of public interest as the appeal over the
settlement of Cameron and Tyler Winklevoss’[1] suit against The Facebook Inc. and its
CEO, Mark Zuckerberg. Everywhere we go, we are asked about this case. And with rare
exceptions, what most people think they know about this case is wrong.

Most people seem to think that after agreeing to a $65 million settlement package, the
Winklevosses decided they would like to renegotiate the settlement price, and went to court
for that purpose. If that were an accurate summary, the appeal would have been a fool’s
errand, and we wouldn’t have touched it with a pole of any length. The core of the case
involved the duty of an issuer like Facebook to disclose material facts in connection with a
transaction in its own securities. In its ruling, the Ninth Circuit assumed Facebook owed the
Winklevosses a duty of disclosure.

Unfortunately, though, the court made some surprising rulings about the effect of a general
release in the settlement and of a boilerplate mediation agreement, the net effect of which
was to prevent the Winklevosses from invoking the securities laws to overturn the
settlement. The Facebook Inc. v. Pacific Northwest Software Inc., 640 F.3d 1034 (9th Cir.

While our clients decided not to file a petition for certiorari for reasons unrelated to the
merits, they authorized us to make public our draft so that others affected by the decision
could see what we view as serious issues that affect all parties entering into settlement
agreements in federal cases in general and also weaken the anti-waiver provisions of
federal securities laws. You can read the draft yourself by going to The following summary of the issues shows that the Ninth
Circuit’s decision has immunized fraudulent inducement of a mediated settlement in two
very unexpected ways.

The settlement reached in the mediation called for the issuance of shares of Facebook
common stock to the Winklevosses. In resisting enforcement of the settlement, the
Winklevosses claimed that Facebook violated Rule 10b-5 by failing to make full disclosure
of material facts bearing on the value of those Facebook shares.
The parties agreed in the mediation that the settlement consideration would be $20 million
in cash and $45 million in Facebook stock. They agreed that the stock portion of the deal
would consist of 1,253,000 shares. That works out to $35.90 per share. That sounded right
because Facebook had recently publicly announced a large investment by Microsoft at the
identical price per share.

Unknown to the Winklevosses and their prior lawyers, Facebook had also recently obtained
an expert valuation of its stock (which was unlisted) at $8.88 per share, and used that
valuation to set the exercise price of its stock options. Facebook did not disclose the
existence of this valuation prior to or during the mediation.

Facebook’s lawyers mentioned this prior valuation only after the mediation, when the parties
were negotiating the definitive agreements to implement the settlement, and Facebook
sought a credit for outstanding liabilities of the company the Winklevosses were to transfer
to Facebook as part of the settlement. Facebook asked that, for purposes of calculating the
credit in its favor, the shares be valued based on the previously undisclosed $8.88
valuation. The Winklevoss twins subsequently attempted to rescind because the failure to
disclose constituted securities fraud under Rule 10b-5.

The Ninth Circuit gave two reasons for rejecting that claim for rescission. The first was that
the general release in the settlement rendered the settlement agreement invulnerable
against claims that it was procured by fraud. That ruling is contrary to — but makes no
mention of — decisions of the Supreme Court and five other Circuits. Each of those courts
has held that a settlement agreement containing a general release does not bar a claim that
the settlement was itself induced by fraud.

Dice v. Akron, C. & Y.R.R., 342 U.S. 359, 362 (1952); Griffin v. Kraft Gen’l Foods Inc., 62
F.3d 368, 373 (11th Cir. 1995); Bennett v. Coors Brewing Co., 189 F.3d 1221, 1228 (10th
Cir. 1999); Griffin v. Kraft Gen’l Foods Inc., 62 F.3d 368, 373 (11th Cir. 1995); Fisher Dev.
Co. v. Boise Cascade Corp., 37 F.3d 104, 108 (3d Cir. 1994); Binker v. Commonwealth of
Pennsylvania, 977 F.2d 738, 748 (3d Cir. 1992); Clarion Corp. v. American Home Prods.
Corp., 494 F.2d 860, 864 (7th Cir. 1974); Irish v. Central Vermont Rwy., 164 F.2d 837, 839
(2d Cir. 1947); Plews v. Burrage, 274 F. 881, 886 (1st Cir. 1921).

If that were not the rule, dishonest parties could obtain settlements by (for example) falsely
representing the limits of their insurance coverage. The Ninth Circuit’s ruling applies to
every settlement of federal claims within the circuit’s jurisdiction, not just settlements that
involve the transfer of securities.

The second ground given by the Ninth Circuit was based on a standard mediation
confidentiality agreement the parties signed at the outset of the mediation — a kind of “what
happens in Vegas stays in Vegas” deal. That agreement, the court said, “precludes the
Winklevosses from introducing in support of their securities [fraud] claims any evidence of
what Facebook said, or did not say, during the mediation.” 640 F.3d at 1041.

The Winklevosses had argued that under Section 29(a) of the Securities Exchange Act of
1934, any agreement purporting to waive a securities law claim in advance is voidable. The
mediation confidentiality agreement, as applied here, was just that: a prospective
agreement that rendered it impossible to prove any fraud that took place during the
mediation. The Ninth Circuit disagreed, construing Section 29 narrowly to apply only to
“express” waivers and not to indirect waivers that accomplish the same end.

The opinion is contrary to — but makes no mention of — decisions of four other circuits
holding that Section 29(a) and substantively identical federal securities statutes apply
equally to direct and indirect waivers. See AES Corp. v. Dow Chem. Co., 325 F.3d 174, 180
(3d Cir. 2003); McMahan & Co. v. Wherehouse Entm’t Inc., 65 F.3d 1044, 1051 (2d Cir.
1995); Rogen v. Ilikon, 361 F.2d 260, 265, 268 (1st Cir. 1966); Can-Am Petroleum Co. v.
Beck, 331 F.2d 371, 373 (10th Cir. 1964).

The Ninth Circuit’s opinion guts the Securities Act’s anti-waiver provision. Your stockbroker
cannot protect against securities fraud claims by having you sign an agreement agreeing
that no such claims will be brought. But, under the Winklevoss decision’s oddly formalistic
logic, your broker can immunize himself against such claims by having you sign an
agreement that all communications between your broker and you will be confidential and
will not be revealed in any judicial proceeding or arbitration.

Fortunately for the Winklevosses, the stock they agreed to accept in the mediation has
skyrocketed in value in the succeeding years. But that does not excuse or rectify
Facebook’s failure to make full disclosure. Had the $8.88 valuation been disclosed,
undoubtedly the negotiations would have turned out differently. That equality of information
is precisely what Rule 10b-5 commands and why it stands as a cornerstone of our
securities market system. Yet it was swept aside here by a decision that is profoundly at
odds with precedent and common sense.

--By Jerome B. Falk Jr. (pictured) and Sean M. SeLegue, Howard Rice Nemerovski Canady
Falk & Rabkin PC

Jerome Falk and Sean SeLegue are members in the San Francisco office of Howard Rice.
They are certified appellate specialists, State Bar of California Board of Legal
Specialization, who represented Tyler and Cameron Winklevoss, and Divya Narendra, in
their appeal from the enforcement of a mediated settlement agreement.

The opinions expressed are those of the authors and do not necessarily reflect the views of
the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general
information purposes and is not intended to be and should not be taken as legal advice.

[1] For simplicity, the three plaintiffs, Tyler and Cameron Winklevoss and Divya Narendra,
are referred to collectively here as “the Winklevosses.”

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